Income tax deductions are rather like hard truths. A client may not want to hear that an item is not deductible, but you know in your heart of hearts that you cannot, in good conscience, advise them otherwise. No doctor relishes the prospect of telling a patient that he is terminal. Often met with a similar grief-stricken reaction, explaining to a client that the “big ticket” deduction that they wanted to claim (or in my case, as a tax controversy attorney, that the IRS has already disallowed) is wholly without merit. I cannot imagine that the anger, bargaining, and other stages of grief witnessed by that doctor delivering the bad news to her patient, because I have witnessed some rather grandiose reactions in my own (non-life-and-death) practice.
Certain deductions are straightforward. Others, however, are buried in a morass of Code sections, Treasury Regulations, and case law. It is in this mire that the deductibility of legal and professional fees can be found. There is no standard rule with respect to deducting fees, nor are there any specific code sections are regulations that directly deal with such deductibility. Although I am loath to repeat the most often used sentence of law school, “it depends,” this is often the tack I am forced to take—much to the client’s great chagrin.
In this article we will examine the deductibility of legal and professional fees in a variety of contexts. By the end, I hope that you will have a better grasp of how to analyze when a fee may be a deductible expense and when you can advise a client, without reservation or compunction, that the fee may never be deducted…no matter how much the client believes it is justified.
Overview
Fees fall into a number of categories with respect to deductibility. A fee may be a deductible “ordinary and necessary” trade or business expense under IRC § 162 (and other sections we’ll discuss in more detail below), or the fee may be a nondeductible personal expense pursuant to IRC § 262. A fee may be deductible if it is attributable to property held for the production of rents or royalties under IRC § 212, or it may be a deductible cost paid by trusts and estates if it meets the requirements of IRC § 67(e). Certain losses are deductible under IRC §165, as are certain startup or organizational expenses under IRC § 195, IRC § 248, and IRC § 709.
If an expense was incurred prior to January 1, 2018 (or after December 31, 2025), a taxpayer may be able to deduct legal or professional fees related to activities engaged in for the production of income under IRC § 212 as miscellaneous itemized deductions. Within this time frame, a taxpayer may only claim a deduction for legal and professional fees if they qualify as above the line deductions under IRC § 212. Expenses that don’t qualify under the above categories are likely nondeductible personal expenses or capitalized expenditures.
Personal expenses are not deductible pursuant to IRC § 262.[1] Similarly, capital expenditures are not deductible under IRC § 263—though they may be amortized or depreciated, depending on the nature of the expense. Legal and professional fees that are related to an activity not engaged in for profit, so-called “hobby expenses” under IRC § 183(b)(2) are considered miscellaneous itemized deductions, subject to the 2018-2025 suspension of miscellaneous itemized deductions.[2] Even if legal or professional fee may be deductible under IRC § 212 is a non-business expense, if it is otherwise disallowed by another provision in the Code, then (and this should come as little surprise if you’re paying attention) no deduction is permitted.[3]
Finally, fees incurred by one taxpayer but paid by another are generally not deductible. Thus, for example, a corporation which paid legal fees to defend the shareholder against criminal tax charges are not deductible by the corporation (and were, in fact, a constructive dividend to the shareholder).[4] A limited exception exists when the expenditure was made by a taxpayer to protect or promote his or her own business.[5]
Trade or Business Expenses
The most straightforward deduction for legal and professional fees are those fees incurred as “ordinary and necessary expenses” paid or incurred during the tax year in carrying on a trade or business.[6] Breaking this down into bite-size pieces, the fees must be incurred in carrying on a trade or business, and they must be ordinary and necessary. Easy enough. It goes without saying (but I’ll say it anyway) that the fees must be paid or incurred during the tax year in which the taxpayer seeks to deduct such fees. Legal and professional fees must be reasonable in amount and (generally) must be paid by the person to whom the services are rendered.[7]
The trouble comes in defining a “trade or business” for purposes of the Code. In Commissioner v. Groetzinger, the Supreme Court held that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.[8] once the determination is been made that a taxpayer is engaged in trade or business, the taxpayer must substantiate that the legal or professional fees were incurred in carrying on that trade or business, i.e., that the fees bore a “proximate” relationship to the trade or business.[9]
The trade or business expense must be both “ordinary” and “necessary.” In Commissioner v. Tellier,[10] the Supreme Court noted that the principal function of the term ordinary is to clarify the distinction between those expenses that are currently deductible and those that are capital expenditures. Additionally, the term ordinary has been defined as “normal, usual, or customary.”[11] To be “necessary,” an expense need only meet the minimal requirement that it be appropriate and helpful for the development of the taxpayer’s business.[12] Finally, the fees must be “reasonable and are in fact payments purely for services.”[13] A fee is reasonable provided that the parties fairly contracted for the arrangement.[14]
Legal and professional fees incurred by a taxpayer seeking advice regarding an employment contract are deductible as ordinary and necessary expenses of carrying on a trade or business, because the taxpayer is considered to be engaged in a trade or business while performing services as an employee.[15]
It should be noted that after December 22, 2017, no deduction is allowed under IRC § 162 for any settlement or payment related to sexual harassment or sexual abuse, if such settlement or payment is subject to a nondisclosure agreement, or for any attorney’s fees related to such settlement or payment.[16] This is so, even if the costs and fees would otherwise have been deductible under IRC § 162.
Nonbusiness Expense (Related to the Production of Income)
Not quite as straightforward, but still manageable, a taxpayer may deduct expenses if they are paid or incurred for the production or collection of income,[17] paid or incurred for the management, conservation, or maintenance of property held for the production of income,[18] or paid or incurred in connection with the determination, collection, or refund of any tax.[19] It should be noted, however, that these IRC §212 deductions are generally “miscellaneous itemized deductions,” and will not, therefore, be available again until 2025. Even if an expense is deductible under IRC § 212, it must be ordinary and necessary and reasonable in amount.[20] Importantly, the IRC § 212 deduction, if allowed, is only available to individuals,[21] estates,[22] and trusts[23]—but not to corporations or partnerships.[24]
Two categories of nonbusiness expenses are not considered miscellaneous itemized (below-the-line) deductions. First, expenses attributable to property held for the production of rents or royalties are deductible above-the-line expenses pursuant to IRC § 62(a)(4). Second, certain costs incurred by estates and trusts are also excepted from the definition of miscellaneous itemized deductions pursuant to IRC § 67(e).
Even if the taxpayer’s activity with respect to property held for the production of rents or royalties does not rise to the level of a trade or business, the taxpayer is allowed and above-the-line deduction for expenses related to that activity, meaning that such expenses are not considered miscellaneous itemized deductions. The IRS has specifically stated that expenses incurred when resolving tax deficiencies related to income producing property are deductible under IRC § 62(a).[25] Further, amounts paid for tax advice related to property held for the production of rents or royalties, such as the preparation of Schedule E, are deductible.[26]
It is important to note, however that expenses paid or incurred for defending or perfecting title to property or costs incurred in developing or improving property constitute a part of the cost of the property and are not deductible expenses.[27] Such expenses must be capitalized.[28] Interestingly, legal or other professional fees incurred in protecting or asserting a right to property of the decedent (under a will) or as a beneficiary (under a testamentary trust) are similarly not deductible.[29]
Expenses Related to Activities Not Engaged in for Profit
An activity is not engaged in for profit is one that does not meet the tests of IRC §162 for a trade or business expense or IRC § 212(1) or IRC § 212(2) for expenses incurred in connection with the production or collection of income and expenses incurred in connection with the management, conservation, or maintenance of property held for the production of income, respectively.[30] IRC § 183 permits deduction of an expense related to an activity not engaged in for profit if the deduction would otherwise be allowed without regard to whether or not it was engaged in for profit under IRC § 183(b)(1) or if the gross income from the activity exceeds the deductions allowed under IRC § 183(b)(1).[31]
Because legal and professional fees are not otherwise allowed without regard to whether or not the activity was engaged in for profit, and because IRC § 183(b)(2) (with respect to excess gross income) is a miscellaneous itemized deduction, it is subject to the IRC §67(g) suspension. So, to put a bow on it, until the suspension sunsets and 2025, an individual will not be allowed to deduct legal and professional fees for hobby expenses.
Organizational and Start-Up Expenses
Pursuant to IRC § 709 and IRC § 248, a partnership or a corporation (respectively) may elect to deduct organizational expenditures, including legal and other professional fees, in the tax year in which the entity commences operation to a limited extent. The amount is limited to the lesser of the actual amount of the expenses, or $5,000.[32] Under IRC § 195(b)(1), a taxpayer may elect to deduct (a limited amount of) startup expenditures including legal and other professional fees. Under either of these regimes, if an election is made, the taxpayer (entity or individual) must amortize the balance over 15 years.[33] The term “start-up expenditure,” does not include any amount for which a deduction is allowable as interest expenses,[34] taxes,[35] or research and experimental expenses.[36]
Fees as Losses
Losses incurred in a trade or business, incurred in a transaction entered into for profit (albeit not connected with a trade or business), or casualty losses, are deductible under IRC § 165—subject to the loss limitation rules of IRC § 165(c) for individuals. Legal or other professional fees may never be included in a casualty loss deduction.[37] This is so because the amount deductible as a casualty loss is calculated pursuant to Treas. Reg. § 1.165-7(b)(1).
To be allowable as a deduction under IRC § 165, a loss must be evidenced by “closed and completed transactions, fixed by identifiable events,” and actually sustained during the taxable year.[38] Thus, for legal or professional fees to be deductible, they must be related to a completed loss. For example, expenditures consisting of legal, engineering and accounting fees, travel expenses of witnesses for hearings, and other expenses incident to the preparation of briefs in relation to a contest of a television broadcasting license before the FCC, which was ultimately unsuccessful, was permitted to be deducted as a loss under IRC § 165.[39] It should be noted, however, that amounts constituting “losses” which are deductible by other taxpayers under IRC § 165, do not constitute “investment expenses” under IRC § 804(c)(1).[40] Similarly, the legal and professional fees incurred in an abandoned business acquisition or reorganization plan have been found to be deductible.[41]
Interestingly, if a corporation is liquidated and dissolved organizational expenditures that were not previously deducted are fully deductible under IRC § 165 in the year in which the corporation is dissolved.[42]
Capital Expenditures
Under IRC § 263(a), no current deduction is permitted for expenses classified as “capital expenditures,” which includes any amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.[43] Further, a taxpayer must capitalize, rather than deduct, legal and other professional fees paid to defend or perfect title to property.[44]
Origin of the Claim Test
In the world of legal fictions, the origin of the claim test sits on a seat of honor. The test is entirely “court created” and was enunciated by the Supreme Court in U.S. v. Gilmore.[45] The court observed that “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was business or personal.”
Thus, if the legal fees were incurred in a quiet title action, i.e., it was incurred to perfect title to real property, the fees would not be deductible, because fees incurred to perfect title must be capitalized under IRC § 263. If, however, legal fees were incurred in a corporate breach of contract case, they would be related to—or could be said to “originate from”—a deductible trade or business expense (assuming all of the other IRC § 162 tests were met). When determining the origin of the claim, courts look to all facts and circumstances involved in the case itself.[46]
If, for example, legal and other professional fees were incurred with respect to a divorce proceeding and property settlement agreement, these would be nondeductible personal expenses under IRC § 262.[47] If the property settlement dealt with one spouse seeking to obtain the right to income from marital property (such as rentals or even profits from the other spouse’s corporate interests), courts have held that such fees would be deductible.[48]
Tort fees may be deductible if the claim arises out of the taxpayer’s trade or business. For example, a corporation may deduct legal and professional fees incurred in defending a wrongful death action, so long as the employee was acting within the scope of its employment.[49] If, however, the fees are expended in connection with a personal injury claim not related to the taxpayer’s trade or business, the fees would not be deductible.[50] Slander and libel actions, so long as they are related to the taxpayer’s trade or busines (such as seeking lost profits) may be deductible under the origin of the claim test.[51]
Conclusion
As you can see, the rules regarding the deductibility of legal or other professional fees are complex and depend entirely on the underlying expense. If a fee is incurred in relation to a trade or business expense, unless it is a capital expenditure, it will likely be deductible. On the flipside, if an expense is incurred for personal reasons, it will likely not be deductible. The heart of the issue is the gray area between business and personal expenses. This is made ever murkier through the application of the origin of the claim test.
I hope that this article will enable you, the tax practitioner, to begin to analyze whether or not a legal or professional fee may be deductible by your client. Law review articles can be written on each subsection, but that was not my intent with this article. Though lengthy, it is by no means an exhaustive study on the subject. There are lots of ins, outs, and what have you’s that I glossed over for the sake of not getting mired in every little nuance.
Footnotes:
[1] Certain expenses related to alimony (IRC § 71), charitable contributions, etc., may be deducted under other sections of the Code.
[2] See Treas. Reg. § 1.67-1T(a)(1)(iv).
[3] Treas. Reg. § 1.212-1(e).
[4] Hood v. Commissioner, 115 T.C. 172 (2000).
[5] See, e.g., Lohrke v. Commissioner, 48 T.C. 679 (1967).
[6] IRC § 162(a).
[7] See Treas. Reg. § 1.162-7.
[8] 480 U.S. 23, 35 (1987).
[9] Kornhauser v. United States, 276 U.S. 145 (1928); Stark v. Commissioner, T.C. Memo 1999-1
[10] 383 U.S. 687, 688-89 (1966).
[11] Deputy v. DuPont, 308 U.S. 488, 495 (1940).
[12] Rothner v. Commissioner, T.C. Memo. 1996-442 (citing Tellier, 383 U.S. at 689). Him
[13] Treas. Reg. § 1.162-7(a).
[14] Treas. Reg. § 1.162-7(b)(2).
[15] Treas. Reg. § 1.162-17(a); O’Malley v. Commissioner, 91 T.C. 352, 363–64 (1988); Rutt-Hahn v. Commissioner, T.C. Memo 1996-536.
[16] IRC § 162(q).
[17] IRC § 212(1).
[18] IRC § 212(2).
[19] IRC § 212(3).
[20] IRC § 212; Treas. Reg. § 1.212-1(d).
[21] Id. (flush language).
[22] IRC § 641(b).
[23] Id.
[24] Clymer v. Commissioner, T.C. Memo 1984-203 (corporations); Surloff v. Commissioner, 81 T.C. 210 (1983) (partnerships).
[25] Rev. Rul. 92-29.
[26] IRS PLR 9234009.
[27] Treas. Reg. § 1.212-1(k).
[28] Treas. Reg. § 1.263(a)-2(e).
[29] Treas. Reg. § 1.212-1(k).
[30] IRC § 183(c).
[31] IRC § 183(b)(2).
[32] Reduced, but not below zero, by the amount that the organizational expenditures exceed $50,000. IRC § 248(a)(1); IRC § 709(b)(1)(A).
[33] IRC § 248(a)(1) (corporation); IRC § 709(b)(1)(A) (partnership); § 195(b)(1) (individual).
[34] IRC § 163(a).
[35] IRC § 164.
[36] IRC § 174.
[37] See IRC § 165(h)(3); Treas. Reg. § 1.165-7(b); Tarsey v. Commissioner, 56 T.C. 553 (1971).
[38] Treas. Reg. § 1.165-1(b).
[39] Rev. Rul. 56-520; Rev. Rul. 86-71; Jefferson-Pilot Corp. & Subsidiaries v. Commissioner, 98 T.C. 435, 457 (1992), aff’d, 995 F.2d 530 (4th Cir. 1993).
[40] I.R.S. AOD-1980-131 (May 27, 1980) (citing Equitable Life Insurance Co. of Iowa v. United States, 340 F.2d 9 (8th Cir. 1965)).
[41] Domenie v. Commissioner, T.C. Memo 1975-94 (acquisition); Rev. Rul. 67-125 (reorganization).
[42] Malta Temple Ass’n v. Commissioner, 16 B.T.A. 409 (1929); Shellabarger Grain Products Co. v. Commissioner, 146 F.2d 177 (7th Cir. 1944); Bryant Heater Co. v. Commissioner, 231 F.2d 938 (6th Cir. 1956), aff’g T.C. Memo 1954-201; Kingsford Co. v. Commissioner, 41 T.C. 646 (1964).
[43] IRC § 263(a)(1).
[44] See, e.g., Wellpoint, Inc. v. Commissioner, T.C. Memo 2008-236, aff’d, 599 F.3d 641 (7th Cir. 2010); Flint v. Commissioner, T.C. Memo 1991-405; Estate of Franco v. Commissioner, T.C. Memo 1980-340.
[45] 372 U.S. 39, 49 (1963).
[46] See Guill v. Commissioner, 112 T.C. 325 (1999).
[47] Treas. Reg. § 1.262-1(b)(7).
[48] See Van Sickle v. Commissioner, T.C. Memo 1986-538; Hahn v. Commissioner, T.C. Memo 1976-113; Commissioner v. Estate of Goldberger, 213 F.2d 78 (3d Cir. 1954); Glassman v. Commissioner, T.C. Memo 1997-497.
[49] Kopp’s Co., Inc. v. United States, 636 F.2d 59 (4th Cir. 1980).
[50] Dickason v. Commissioner, 20 B.T.A. 496 (1930); Hall v. Commissioner, T.C. Memo. 1980-485.
[51] Draper v. Commissioner, 26 T.C. 201 (1956); but see Stiebling v. Commissioner, T.C. Memo 1994-233 (fees not deductible for damage to personal reputation).
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